$12 BILLION HEDGE FUND: The stock market has changed, and we’re going to have to do things differently

“We think the challenges, consolidation, and changes in the industry are due to one main factor: There isn’t enough alpha to make everyone happy,” Balyasny said in the letter, which was reviewed by Business Insider. Balyasny declined to comment.

He identified three key questions for equity long/short funds, or those that bet on and against stocks.

Can long/short strategies work in an ETF and index-flow-led market?

ETFs, which simply track an index, have hoovered up assets at a high rate over the past decade. US-listed ETFs saw $283 billion in net inflows during 2016, taking aggregate assets under management to $2.5 trillion, according to Citigroup.

Balyasny notes that passive investors now own more than one-third of the US stock market and fundamental stock investors make up only a small fraction of total trading each day.

This has a few implications, according to Balyasny — in particular, an increase in the relative importance of stock-price catalysts, such as earnings releases. From the letter:

“Day-to-day action is very ETF-driven. While this action won’t change the ultimate valuation of individual companies, it will increase short-term correlations. Portfolio construction needs to be tight and tilts need to be very well managed to navigate these powerful flows. This makes catalysts, earnings, and other events extremely important to play — and play correctly — because that is when dispersion is most likely to occur.”

Balyasny cites Japan as an example of what happens to markets with high levels of passive ownership. More than 70% of Japanese stocks are passively owned, according to the letter, given the Bank of Japan’s stock-buying program, “yet liquidity in Japan is fine, and the fundamental stock selection opportunities remain robust,” he said.

In other words, passive investing doesn’t kill stock-picking. It just puts an emphasis on calling the big catalysts for stock moves right.

Can long/short investing work in a crowded field?

Another common complaint among investors: Everyone is chasing the same trades.

“While crowding has been reduced from last year’s peak, most verticals are still pretty crowded,” Balyasny said. “A correct, fundamentally variant view is hard to come by, and the alpha is short-lived as others catch on.”

Still, it’s possible to find unique ideas and deliver alpha, according to the letter.

“The market is just very competitive,” he said. “While the business is tough in the short run, it is ultimately good for survivors.”

Can long/short work in markets dominated by computers?

Quant funds have become popular with investors and are hoovering up assets. According to a recent Credit Suisse survey, about 60% of global institutional investors said they were likely to increase allocations to incorporate some quantitative analysis over the next three to five years, with pensions showing the most interest.

According to Balyasny, it isn’t a case of fundamental investing versus quant investing; the two need to combine. From the letter:

“Some of our worst trades are caused by an over-reliance on data without a variant fundamental view (e.g., a short position in a fundamentally challenged business with deteriorating current data where results come in close enough in light of low expectations to cause a big squeeze).

“On the flip side, some of our best trades have been when our teams identify some fundamental inflection in a business that has not been picked up yet in the data. Each approach can be successful on its own if practiced by a top team, but combining the two will lead to the best results.”

The letter said Balyasny’s Atlas Global fund was basically flat for the year to date, while the Atlas Enhanced fund was up 0.78%.

“We believe that as we continue to scale up deployment and enter summer earnings season, returns should improve back to our target range,” Balyasny said.